Bollinger Band Squeeze Strategy Explained – Backtest And Performance
Last Updated on March 10, 2023
Volatility goes up and down in any financial market. Low volatility is often followed by periods of high volatility and vice versa. Bollinger Bands are one of the tools a trader can use to measure volatility. What is the Bollinger Band Squeeze about?
The Bollinger Band Squeeze strategy is about going in the same direction as the breakout after a period of low volatility. The assumption is that the breakout sets the tone of the action over the following days (or weeks – depending on the time frame).
Let’s dig in and see if we can make a profitable backtested Bollinger Band Squeeze strategy.
Explanation of Bollinger Bands and how they work – example
Bollinger Bands are a trading tool that aids traders in understanding the price range or volatility of the asset you are looking at.
The center of the Bollinger Bands represents the average price of the asset you’re tracking over the lookback period. The lookback period can be one day or 1000 days; you decide – the lookback period is part of the parameters you type in. The two bands, the bands around the center, represent the price range of the asset. The further apart the bands are, the more volatile the asset is.
Here’s an example of how the Bollinger Bands look like:
The above chart shows Bollinger Bands with a 25-day lookback period and 2 standard deviations away from the 25-day mean. As you can see, the bands contract and expand depending on the price action. In volatile periods the bands expand, and during low volatility, they contract.
When the asset’s price approaches the upper band, it may indicate that the asset is overbought, meaning that the price has gone up too much and is likely to come down and revert to the mean.
Conversely, when the price approaches the lower band, it may indicate that the asset is oversold, meaning that the price has gone down too much and is likely to go up. How you trade Bollinger Bands depend on the asset you are trading. For example, overbought and oversold work nicely for stocks but not for commodities.
If you want to read more about Bollinger Bands, please read our separate article:
Bollinger Band Squeeze Trading Strategy
When Bollinger Bands contract or come together, volatility falls. This might be an indication of a breakout, either up or down. A squeeze refers to such periods of low volatility. When the price later breaks out, up or down, you have a squeeze:
The blue square on the chart shows such a squeeze. Volatility contracted because the asset was consolidating before it broke up and continued in the same direction for many days.
Thus, periods of low volatility are how you identify a potential squeeze.
Bollinger Band Squeeze strategy backtest – does it work?
Let’s try to backtest such a strategy to find out if we can find any trading rules and settings that work.
We start by making an indicator that looks at the difference between the upper and lower band:
The lower pane shows the difference between the upper and lower bands. When volatility contracts, the indicator goes down.
Can we use the squeeze indicator to make a profitable trading strategy?
Let’s make some trading rules. We use the following assumptions:
- We use weekly bars (it seems to work better than daily)
- We use 10-week data
- We create a volatility band (10 weeks) that is the difference between the upper and lower Bollinger Bands
- We create a 10-bar RSI value for the volatility bands
The buy and sell signals read like this:
- The RSI of the volatility bands must be lower than 45
- The close (of the asset) must set a new 5-day high
- We sell after 20 weeks
The strategy doesn’t do particularly well for any asset, perhaps except for consumer staples. For example, this is how it performs on Pepsi (PEP):
The strategy doesn’t beat buy and hold, though (12.5% vs. 14.8%), but is only invested 61% of the time.
We tried many different versions of the strategy but to no avail on any asset.
Bollinger Bands squeeze strategy – conclusions
We tried our strategy on many assets with no success. We also tried several twists of the strategy – also with no success. Thus, we don’t think you should trust anecdotal evidence explaining how to trade this strategy. As far as we can see, plenty of other and better indicators are out there.
Brief About John Bollinger: The Founder of Bollinger Band Squeeze Strategy
After knowing much about Bollinger Band Squeeze Strategy, let us briefly know about its developer John A. Bollinger who was born in 1950. He dons multiple skills in being an author and financial analyst. More so, he has contributed to the stream of technical analysis. And, of course, the development behind the Bollinger Bands that you have been reading about in this article.
He launched his book Bollinger on Bollinger Bands twenty-two years ago. The translation of this theory has been done into 11 languages. Earlier in 1987, he had published a newsletter called Capital Growth Letter to facilitate technical analysis of the financial markets. Bollinger began the development of Bollinger Bands in the 1980s. Since that time, he had been trading options. Much of his analytics had involvement of volatility.
One big reason behind the contribution of Bollinger in using the volatility deviation was the adaptability of trading bands. When Bollinger Bands was initially introduced to the public on a business news television network in America, it had no identity. When the interviewer of the program asked Bollinger about what these are called, he replied, ‘’Let’s call them Bollinger Bands’’. And thus, the name was given.
Bollinger Bands squeeze strategy – FAQ
Let’s end the article with a few FAQ about the strategy:
How does the Bollinger Band Squeeze Trading Strategy differ from other trading strategies, and what are the advantages and disadvantages of using this strategy in different market conditions?
This is a breakout strategy; thus, it behaves differently than mean reversion strategies. This means the win rate is lower, and you will suffer from “whipsaws”. That doesn’t mean it’s a poor strategy; it depends on the expected returns. You must backtest the strategy to determine if it has a positive expectancy. Generally, it doesn’t matter what strategy you use as long you have “proven” that it has a positive expectancy.
How do traders use Bollinger Bands in conjunction with other technical analysis tools to maximize the effectiveness of the Bollinger Band Squeeze Trading Strategy?
There is no right or wrong in trading. If you backtest a strategy, it can work with the RSI indicator, the IBS indicator, or any other indicator.
What are some common mistakes that traders make when using the Bollinger Band Squeeze Trading Strategy, and how can these mistakes be avoided?
The two biggest mistakes apply to all forms of trading: not having a positive expectancy, and second, if they have a positive expectancy, not following the strategy. The latter is normally a result of trading biases.
We believe mechanical trading is the best approach to trading to avoid many of these issues.
- Mechanical Trading Strategies – Advantages with Mechanical Rules and Edges
- Mechanical Trading Strategies Vs. Discretionary Trading Strategies
Can the Bollinger Band Squeeze Trading Strategy be used effectively in trading different financial instruments (e.g. stocks, futures, options), or is it better suited to certain types of assets?
All assets are not the same. Stocks are prone to mean reversion, while commodities are not. Thus, you can’t expect a strategy to work on all assets.
How has the Bollinger Band Squeeze Trading Strategy performed historically, and what are some examples of successful trades that have been executed using this strategy?
This answer can’t be answered (see the FAQ above). For example, the strategy might work on a commodity but not on stocks.
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